Taxing times

Zhong Lun Law Firm’s Robert Lewis gets to grip with the changing tax laws facing law firms in China

Having been on the road on business in the US and now South Africa almost non-stop since Chinese New Year, I am just now coming up for air to pick up again on the topic of the regulatory environment for foreign law firms in China.

First, I need to close off on one point from my last blog entry. The week following my last posting, where I mentioned the disparate tax treatment of foreign and domestic law firms in China, all partners in the firm were called into a meeting to discuss the recent changes in the tax code for Chinese law firms. In short, as anticipated, the old scheme of low tax rates and no deductions for domestic law firms has been replaced with a new scheme of standard rates and deductions. This means that the take-home pay for partners in Chinese law firms will likely take a hit, but that’s life in the big city.

Robert Lewis

For the foreign law firms, the good news is that their list of complaints regarding the regulatory scheme in China has now been reduced by one (although this remains on the list of complaints in the latest draft of the AmCham Legal Services Committee white paper). The bad news for the foreign firms is that, predictably, this has had no apparent impact on the fundamental dynamics of the China legal services market. he issue of disparate tax treatment was always a bit of a make-weight red herring point in my book in any event. All foreign firms that are unprofitable in China only because of tax rates, please raise your hands. You’ll have to raise them a bit higher, as I am having trouble seeing you. If, as indicated in my last blog posting, up to 70 per cent of the China offices of foreign law firms cannot even cover local costs let alone partner draws and profit shares, the problem is not tax rates.

So what are the principal regulatory challenges, actual or perceived, for foreign firms in China? The key issues are those that I outlined at the end of my last blog. Since no one will remember (even I don’t remember, it has been so long) what these main points are, I will repeat them here: limitations on 1) permitted scope of legal practice, 2) rights to hire Chinese lawyers to provide Chinese legal services, and 3) rights to appear before various government agencies.

Let’s take a look at each of these points, taking the last point first just to get it out of the way. In my personal view, the limitations on foreign lawyers appearing before certain Chinese regulatory authorities are an unnecessary restriction which should be relaxed in due course. f course, my opinion counts for little (okay, nothing). If the Chinese authorities want to restrict such access, there is not much any of us can do about it. I can understand why the foreign bar continues to raise this as an issue, but so far this is not in the offing.

The remaining issues of scope of practice and hiring of local Chinese lawyers by foreign law firms in China are related. The unremarkable rule in China is that lawyers not admitted to practcse in China are not permitted to practise Chinese law, but the adjunct rule is that when licensed Chinese lawyers are hired by foreign law firms in China they must formally suspend their practising licence certificates and may not perform Chinese legal services. So foreign lawyers in the China offices of foreign law firms cannot practise Chinese law and the local lawyers they hire can’t either.

That would appear on its face to be quite an onerous restriction, but in practice foreign law firms have had and continue to have a fairly wide scope in which to operate in China. The other way to approach this same point is to pose the question, what have the foreign law firms in fact been doing in China for the last 20 years if they cannot (legitimately) practise Chinese law?

First of all, here’s what they are not doing – foreign firms are not issuing formal Chinese legal opinions or appearing in court in China. Those are the bright lines that cannot be crossed. But foreign law firms are doing everything short of this. They run China deals for foreign clients and even advise on issues of Chinese law, in most cases based on legal research done by local Chinese lawyers on their staffs whose practising licences are formally suspended. To cover the discomforting regulatory issues, they append a fig leaf disclaimer to their advice memoranda to the effect that they are not licenced to practise law in China so their advice represents only their “best understanding” of Chinese law and practice and is not considered to be a formal legal opinion. Some don’t even both with the disclaimer – most clients of foreign firms in China simply don’t care and Chinese regulators have adopted a relaxed posture when it comes to enforcement.

Still, as a matter of black letter law under the foreign law firm regulations, this is not permitted. This is where China’s WTO commitments come to the aid of the foreign law firms. Under the terms negotiated by the US and EU, foreign law firms in China may advise clients on foreign and international law and practice in the context of the Chinese legal environment. In other words, foreign law firms do not need to be ignorant of the requirements of Chinese law. In fact, quite the opposite – they should be up-to-date on Chinese law and regulations so that they can provide permitted advice to clients in the context of the Chinese legal environment (all foreign lawyers in China owe a big debt of gratitude to the EU negotiators who added this element on top of what the US negotiators had achieved). The other important bit is the ability of foreign law firms to advise on international practice. When combined with the China legal environment carve-out, the foreign firms have more than enough regulatory cover to advise on corporate deals in China not only with impunity but with the full backing and blessing of China’s WTO commitments.

Here is a simple illustration. A Sino-foreign JV contract must, by law, be governed by Chinese law, but other than a handful of terms which are mandated by Chinese law, the balance of the terms (including the likes of governance and termination events) are left to the negotiations of the parties. In this case, it can legitimately be argued that the terms mandated by Chinese law are simply a part of the Chinese legal environment and the other open terms can be negotiated by reference to international practice. Consequently, there is no practical limitation of the role of foreign lawyers in such deals.

The argument is even stronger when the cross-border transaction documentation is not required to be governed by Chinese law, which is the case in the vast majority of transactions. And this is only on the traditional inbound side of the ledger. For outbound deals, the regulatory basis for the foreign lawyer’s role in China is completely unassailable.

This brings us to the inconvenient question of actual issues of interpretation of Chinese law. No matter how you slice it, this has to be considered the practice of Chinese law, whether styled as ‘advice’ as opposed to an ‘opinion’ and whether or not you cover your private parts with a skimpy disclaimer of dubious legal effect. Yet this is what all foreign law firms in China do as a part of their daily practice. The regulations contemplate that foreign law firms will outsource this part of the work to local law firms, but most foreign lawyers are unwilling to take bread off of their table and hand it to the local firms, particularly at the risk of losing the client to the local firm.

When I was working with Lovells we tried to be a bit more circumspect and consult with local lawyers on novel issues of Chinese law as appropriate, but the best that can be said is that I was straddling the line. Most foreign lawyers in China have both feet on the wrong side of the line and know it. It creates some awkward moments. As a China-based foreign lawyer you are in the business of advising major multi-national clients on how to comply with all Chinese regulatory requirements applicable to their business operations in China, but yet foreign law firms are in many cases much less strict in their own regulatory compliance management. It is something you don’t like to talk about in front of clients.

Ten years ago I was invited to meeting with the Ministry of Justice. There were about a dozen managing partners of the Beijing offices of foreign firms from various jurisdictions around the world who were summoned by the MoJ ostensibly to gather market information on how foreign law firms viewed the MoJ’s policies and regulations governing foreign law firms’ activities in China. Most of the participants seemed to accept the premise for the meeting at face value and were remarkably frank in their often harsh assessment of the MoJ’s rules.

I, on the other hand, thought that at best this was an insincere tick-the-box exercise ahead of the issuance of some new regulations governing the legal profession or, at worst, the MoJ’s reprise of the ‘letting a hundred flowers bloom’ campaign. When it was my turn, I said some polite words about how difficult and challenging their job was and how we hoped to be able to offer support for their plans to develop the Chinese legal profession in an orderly manner, blah, blah, blah. (I was actually sincere, but in the context it was just a polite response to my regulator.)

Others at the meeting were not inclined to be so diplomatic. I was more than a bit surprised to hear one of the best-known foreign lawyers in China who headed the Beijing office of one of the top New York law firms baldly state that if the MoJ enforced their rules, they would have to kick all of the foreign lawyers out of China. I was not quite sure if that was an observation or an invitation, but it certainly was not politic.

He was followed by a young Chinese lawyer attending on behalf of her boss, who was too busy to attend. As she enthusiastically recounted the contributions of foreign law firms in China, the MoJ official cut her off to ask if she was a foreign lawyer or a Chinese lawyer. When she admitted to being a Chinese lawyer, he asked what work she did at the foreign firm. Knowing that under a strict interpretation of the MoJ’s rules she could only do translation and other non-law work, she uncomfortably stuttered and stammered her way through five minutes of unrelenting cross-examination from the senior MoJ official chairing the meeting. It was not a pretty sight.

But neither she nor the China-based partner of the New York firm had anything to worry about. It turned out it was simply a tick-the-box exercise after all, and no one at the MoJ was taking names or even seemed interested in enforcing the rules. In fact, it has since become obvious that even agitation from local Chinese lawyers is not enough to get the MoJ to adopt a stricter enforcement policy vis-à-vis the foreign law firms in China.

Case in point, around that same time, local lawyers in Shanghai started complaining loudly that foreign lawyers were breaking the law by flouting the limitations on scope of practice. For a period of several months, there was a steady drumbeat of highly publicised calls for a crack-down on the foreign law firms, and even the Shanghai Lawyers Association joined the campaign to argue for sanctions on foreign law firms.

The international legal press ate it up, and wondered if this portended a new, stricter regulatory environment for foreign lawyers in China. But the MoJ didn’t take up the cause. Many in the international legal press at the time missed the key distinction between the Shanghai Lawyers Association, which is run by the local lawyers, and the MoJ, which is the government agency. It didn’t matter what the Shanghai Lawyers Association said because it had no jurisdiction over the foreign law firms, who reported only to the MoJ. Publicly, the MoJ said nothing, but privately MoJ officials let certain people know that they had no intention of cracking down on the foreign law firms and seemed more than content to let the foreign law firms continue to advise on Chinese law as they always had and as they continue to do today.

After a while, the noise died down, and the status quo was maintained (although this is still one of the most common complaints raised by local lawyers in the smaller Chinese law firms, who appear to think that stricter controls on foreign law firms will result in a flood of new work for them). In an ironic twist, one of the key agitators on the local Shanghai lawyers side later spun out his team of FDI lawyers from one of the leading Shanghai-based domestic law firms to set up a small shop that he then linked up to a US firm to be their captive PRC law firm in an arrangement which was as innovative as it was questionable in terms of its regulatory legitimacy. In any event, not surprisingly, he has not agitated further against the Great Satan foreign law firms in recent years.

But this leads us neatly to the most important ambition of foreign law firms in China – to hire Chinese lawyers to provide Chinese law advice on the foreign law firm platform, i.e. no suspension of the practicing license certificate when hired by a foreign law firm. This is the holy grail, and in fact this again features prominently in the AmCham Legal Committee’s draft white paper for 2013. And the foreign law firms don’t want to hire only the junior Chinese lawyers that have always comprised two-thirds or more of their total professional staffing in their China offices, but also senior partners in top Chinese firms, to be the deal makers and key relationship partners for China inbound and outbound deals.

When I made my move across to Zhong Lun, I assumed as part of my market analysis that the regulatory restrictions on foreign law firms would be substantially relaxed within this decade, both in terms of formally permitted scope of practice and the hiring of Chinese lawyers. But, at least for now, this still looks to be a bit of a quixotic quest on the part of the foreign bar in China because there are no indications that the MOJ is ready to open things up in this manner – yet. The MOJ’s position appears to continue to be that it is too early to make these reforms. They seem intent on maintaining the status quo, which allows a significant amount of scope for the foreign law firms while still giving the Chinese legal profession some continuing protection.

As a practical matter, the restrictions probably are no longer necessary and relaxing them likely will not change the dynamics in the market substantially in any event. First of all, many of the top partners in the leading Chinese law firms already have dual qualification and could be hired across on the strength of their foreign bar qualification (but, of course, would still not be able to issue formal legal opinions). But even if the policy were relaxed, the senior Chinese lawyers that the better foreign firms want to hire are already hugely successful practitioners in their current firms and will not take a cut in pay just for the privilege of working for a foreign law firm. When I was at Lovells, we made a couple of attempts to lure across some top Chinese partners, but we couldn’t afford them. Very few firms could, given their current income levels at their Chinese law firms, and if you bring them across with a high guaranteed base salary, then the performance expectations rise correspondingly. For those who can be bought, there may be a reason which does not portend well for future development of the practice.

There is already some lateral partner movement from top Chinese firms to good foreign firms in the market, but the numbers are not high (about the same as the number of senior foreign lawyers who have moved to top Chinese firms so far!). The bigger part of the market would be for the top junior lawyers with Chinese bar qualifications, but what top foreign firm is going to permit a junior Chinese lawyer to sign off on a formal Chinese legal opinion or go to court on behalf of a key foreign client? The more likely medium-term strategy would be to use these junior Chinese lawyers, who would no longer be required to suspend their practicing license certificates, to provide the basic Chinese law research for the “advice” memos. In other words, the firms would be charging London or New York rates for junior Chinese lawyers to do what their equally-qualified classmates do for half the price across the street at the top Chinese law firms. Of course, supervision and training does matter, but the original advantage that the foreign firms had in this regard ten years ago has long since evaporated at least in the top local firms.

The longer-term strategy would be for the China offices of the foreign law firms to train up these junior Chinese lawyers internally and bring them through as partners with a higher degree of confidence that once across the threshold they can perform at the required standard. But this is already possible for the vast numbers of junior Chinese lawyers who also have a foreign (usually New York) bar qualification. The reality is, however, that even before the downsizing of the China offices of most foreign firms as a result of the fallout from the global financial crisis, there was already a de facto “glass ceiling” for Chinese lawyers in most foreign law firms in China, who saw little chance for partnership. As a result, most of these local top-performing Chinese lawyers tend to see their best path for professional development in the top Chinese firms. This is a function of the economics of the foreign firms themselves and not regulation, so this likely will not change dramatically with any further opening of the legal profession in China.

In prior years, no one in the foreign firms thought it was possible as a practical matter to be able to hire Chinese lawyers directly so they clamored for the next best thing – a JV law office. At the meeting with the MOJ ten years ago described above, every one of the other foreign law firm representatives in attendance said they wanted to be able to set up a JV law office with a Chinese law firm. The irony is that it was already possible for the big international law firms to restructure their China operations such that they could do a JV law office under the closer economic cooperation agreement between mainland China and Hong Kong, but to date not one single leading international law firm has pursued this. (A foreign firm can also have a close but still arms-length cooperation with a semi-captive local firm so long as there is no sharing of profits or underwriting of costs, but there are also only a very limited number of examples of this in the market, only two that I am personally aware of.)

I think there is good reason for this. As I said at the time of the MOJ meeting ten years ago, even if permitted, I would not recommend to my then management in London that we do a JV with a Chinese law firm. The management structures, culture, and profitability are just too different between top foreign firms and Chinese law firms, so any tie-up would be problematic at best and a train wreck at worst. I still feel that way today.

In fact from where I sit today, ten years later, I would not want to dilute any of the multitude of market advantages I feel we have as a top domestic Chinese law firm by formally hooking up with one foreign firm. The better path is for top Chinese law firms to continue to bring in senior foreign lawyers and expand organically. If there is a migration in the other direction as well, that is also fine and natural, and should be permitted and even encouraged.

So I hope the foreign firms finally can achieve this long-held ambition in the near to medium term. And I expect it will not change the dynamics significantly in the market – the Chinese firms have already matured well beyond the point where adding a few more Chinese lawyers in the foreign firms, and legitimizing the Chinese lawyers who are already there, will make much if any difference. In any event, there is room – and important roles – for both Chinese and foreign firms in China. I for one am happy to have the playing field evened out in due course.

Robert Lewis is international managing partner at Zhong Lun Law Firm, based in Beijing